How to ensure attractive investment returns – the right way

Smoothing investment returns and managing volatility

For a pension scheme that is still journeying towards end-game, one of the most important investment decisions that needs to be made is the choice of strategy for your assets.

But, asset returns are not always as smooth as you would like them to be; the ups and downs of the economic cycle affect markets and, if not properly controlled, they could send you off course.

All fiduciary managers will diversify across asset classes as an attempt to address this problem. There will be a mixture of defensive assets alongside growth seeking assets in your overall asset allocation. However, delivering ‘genuine’ diversification involves ensuring that the protection afforded by your defensive investments in the bad times is sufficient to keep you on track whilst your growth seeking assets power ahead in the good times.

This can be achieved by using derivative strategies, allowing significant market exposure to defensive assets, like government bonds, which protect in the bad times; without compromising the allocation to growth seeking assets which are the main driver of investment returns in the good times. Overall, this gives the same growth potential as more traditional strategies, while ensuring that the defensive assets punch above their weight.

Downside protection

Whilst the genuine diversification of a risk-balanced portfolio helps in smoothing out your journey plan, there will always be market stress events that can cause shocks and discontinuities.

We’ve seen this over the recent past with ‘Taper Tantrums’ – those periods when equity markets sell-off alongside rises in Government bond yields as markets adjust to changing expectations of Central Bank monetary policy conditions.

Most fiduciary managers will use a strategy of holding equity put options as a way of guarding against this eventuality. That’s an important part of the toolkit but not always the best approach.

Equity protection strategies are expensive insurance policies when market volatility is high i.e. those periods when you most likely want the protection, are those periods when it is most expensive to buy.

To avoid this dilemma, a wide range of different approaches to portfolio protection should be used, including:

Defensive currencies – The Japanese yen and Swiss franc have the tendency to appreciate in value when market turmoil arises. They represent relatively safe havens and can protect portfolio returns
Precious metals – Gold is a traditional safe haven asset. And, amongst other precious metals, performs well during periods when there is stress in bond markets, inflation fears or when the market judges that central banks are making policy mistakes
Bond market protection –Rising bond yields or rising credit spreads can be a negative influence upon equity returns. Holding protection strategies (usually by using derivatives) can a very flexible and cost-effective way of protecting a portfolio

Dynamically managing your protection allocation is also helpful, to have the right protection investments at the right time and at the right price. You always want to be flexible enough to address the most pressing risks that are apparent. With thoughtful implementation, the protection that your portfolio will need can be provided and costs can be minimised.

Uncertain outlook

As the post-COVID re-opening phase advances, the balance of risks facing the global economy have started to shift. Investment markets entered 2022 at an intriguing point in the economic cycle.

Most economies now have regained their lost growth. This has been substantially assisted by monetary and fiscal policy stimulus.

Looking ahead, it is now the pace of withdrawal of monetary policy support and the taming of inflation that are key issues. 2022 promises robust but lower growth, maybe more benign economic conditions than we have been accustomed to recently. But, the fragility of the global economy has not yet been really tested under tightening policy conditions.

Added to these cyclical influences we see greater geopolitical risks; right now that is evident in Ukraine. Beyond this immediate area of focus, US-China relations and issues around Taiwan are not clearly settled and President Xi might yet roll out further ‘common prosperity’ measures ahead of his upcoming re-election.

2022 also sees key elections in; France, South Korea, Brazil and Australia; and US mid-terms – five nations that have had very different COVID experiences and have differing degrees of populism embedded within the political landscape.

In response to these emerging concerns we had reduced portfolio risk at the end of 2021 to protect returns in the expectation of market volatility increasing.

We think of dynamic management of investment risk in terms of having three levers to pull;

Firstly, we actively manage the overall level of total portfolio risk,
Secondly, we actively manage the allocations between different asset class groups and,
Thirdly, we actively manage the choice of assets within each asset class group.

Allocations are calibrated to suite client objectives, balancing those assets that are playing defence against those that are capturing upside according to our proprietary view of how economic and market conditions will play out.

Now, more than ever, is the time to ensure that your portfolio is properly prepared for the uncertainty that lies ahead and that your fiduciary manager has the right toolkit to dynamically manage your assets.